My opinions on value investing. The idea is to create a value discussion on stocks and concepts. You might find this blog leaning a bit towards Dalal Street but the concepts should travel well across global markets.
Please note that I may or may not have a position in these stocks. Please use these opinions after through independent research and at your own risk.

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Tuesday, April 7, 2015

Why does very high IQ not give you an edge in investing?

“You don't need to be a rocket scientist. Investing is
not a game where the guy with the 160 IQ beats the guy with 130 IQ.”

- Warren
Buffet

In the
hedge fund world you find fund manager after fund manager pitching the
smartness of their investment team to the investors. Some will only hire out of
the Ivy leagues. Some will have an interview process that could match that of
the most competitive companies in the world like Google or Facebook or General
Electric. The results, however, don’t seem to correlate with IQ. Take the
example of Long Term Capital management (LTCM). It was led by John Meriwether
and had Myron Scholes and Robert Merton on the board who shared a Nobel prize!

They had the smartest investment team the world has ever seen and could
probably compete with top research teams at the world’s top labs and
universities. They, under the assumption that inefficiencies in the markets will
converge put on trades with razor thin margins and took lots of leverage. As we
already know markets can be irrational longer than anybody can stay liquid.
There are several examples of irrational markets across the globe. Most closed
end funds like Alliance trust in the UK trade at a discount to the securities
they hold. And in the case of Alliance trust they mostly hold highly liquid
securities and thus very little debate on the market value used to calculate
the NAV. Anyways LTCM eventually got itself into a position where it had so
much leverage and was such a large counterparty risk that it’s downfall would
have brought down the entire financial system. Several banks under the
supervision of the Fed bailed out LTCM in order to avert a financial crisis. There
is a wonderful book about the LTCM debacle if you are interested in the details
called “When Genius Failed: The Rise and Fall of Long-Term Capital Management”
by Roger Lowenstein.

LTCM is
not the only example of smart people losing money in the markets. There are
several others. Buffet routinely says that smarts don’t really help you in the
markets. The question really is why don’t the smarts help? IQ and intelligence
have a few facets to them. The primary problem with the smart people is that
they probably know that they are smart. And this intelligence fact is probably
coming from an exact science like mathematics, physics, engineering, medicine
or the like. The assumptions from exact sciences are not applicable to
investing. There is no 2 + 2 = 4 equation here.

Secondly
and most importantly one has to respect that in the world of value investing
the variables are infinite and thus calculations can show you a bit of the
picture but never the whole picture. One has to respect the fact that there is
a very large unknown and no one really can analyse all the factors to give
accurate predictions of the market.

Thirdly
discipline and psychology for the intelligent investor drive returns much more than the analysis. One has to
be able to get rid of most of the biases and objectively analyse the situation
from a probabilistic standpoint.

That
said please don’t stay away from the markets just because you’re smart. This is
just a lesson in humility and understanding that the rules of more exact
sciences cannot be applied here.